If only alpha were easy

BattleBots is a TV series that originally aired in the early 2000s and was revitalized in 2015. If you aren't familiar with BattleBots, it's a show that has inspired viewers of all ages (including yours truly) to dream about or even dabble in robotics, engineering, and creative design. The premise is simple: An elimination tournament pits robots, built and operated by the competitors, against each other. The robots take seemingly countless forms as the entrants look for any edge over their competition. And season after season, the skill levels and sophistication of designs continue to increase. Each episode, I find myself thinking wishfully about what I would build to dominate the competition. The problem with this, of course, is that I have neither the requisite skills nor materials. Fortunately, I recognized early on that in the distribution of engineering and design skills among all people, I am at the far left side of the bell curve. Conversely, those competing in the BattleBots' tournaments are at the far right side of the curve. Relative to the average person, these professionals are highly skilled, with access to technology, equipment, and processes that the rest of us don't possess. This disparity would no doubt end very badly for me (or my 'Bot as it were) since my opponent would take advantage of my ineptitude quickly and without mercy. As a result, I watch and do not participate!

It's investment pro versus investment pro

In investment management, this would be known as easy alpha—the kind that investment professionals dream about. Unfortunately, easy alpha is only a dream. This is because the vast majority of portfolio managers (PMs), traders, investment experts, and analysts, like you, are highly educated and credentialed, have access to the latest technology and information, and have expert knowledge of the financial markets. In other words, we in the investment management industry dominate the far right end of the investment management talent-distribution bell curve among all people (like my engineering-distribution example above). This means that we are not competing against unskilled know-nothings but rather other highly skilled and motivated counterparts who are also at the far right end of the talent distribution. As a result, operational or execution advantages are difficult to consistently come by. This is where it gets interesting. Investment performance is a zero-sum game (before costs), meaning that for every outperformer, there must be an underperformer. It would be great if active managers could systematically take advantage of unskilled investors so that, as a group, they were the outperformers and the unskilled were the underperformers. But, alas, since the capital markets pit talent against talent, if one talented PM wins, another talented PM has to lose. And it's not even as simple as half win and half lose. In fact, most active managers incur significant costs to ply their talents in their effort to win, ultimately falling to the losing side of the performance scale when measured against costless benchmarks and low-cost index funds, even if they would have outperformed before costs. This combination of talent versus talent and the perpetual drag and compounding of costs is why performance results look so poor, on average, for active managers, particularly over the long run. The challenge for investors using active managers, therefore, is to identify why a particular manager should have an enduring and replicable advantage in a highly competitive market. Find managers who have consistent track records, who have clear investment strategies, and who are willing to stick to their strategies. Further, focusing on the attributes that matter the most— cost being the most powerful—is critical (but by no means a guarantee of success). We believe this combination can improve the odds of outperforming even if there is no silver bullet. Ultimately, whether entering a BattleBots tournament or engaging in active management, it's critical to understand who the competition is and the significant challenge of overcoming that competition. Because of this, for investors looking to maximize the efficiency of their portfolio, there is a clear role for focusing on cost and incorporating indexing. Links to third-party websites will open new browser windows. Except where noted, Vanguard accepts no responsibility for content on third-party websites. All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is no guarantee of future results.

Chris Phillips

Christopher Philips, CFA, heads Vanguard Institutional Advisory Services, which assists and counsels institutional clients, including defined benefit plans, endowments, and foundations. Previously, he led a team of investment-only relationship managers in Vanguard Institutional Investor Services, and served as an senior investment analyst in Vanguard Investment Strategy Group, where he wrote and presented research on various topics, including international investing, indexing, and benchmark selection. Mr. Philips joined Vanguard in 2000. He earned a B.A. from Franklin and Marshall College and is a CFA® charterholder. Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing. Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling. Investments in bond funds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss in a declining market. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries. All investing is subject to risk, including possible loss of principal.